A Quest for the Best Diversifier: Overlaying 60/40 With Alternatives

By Dr. Sonu Varghese via Iris.xyz

The 60/40 stock-bond portfolio has been one of the simplest go-to asset allocation choices to capture the diversification benefit. The problem with a typical 60/40 portfolio is that it still exhibits significant volatility and drawdowns during sustained bear markets, or when stocks and bonds are both falling (as in February 2018).  For example, a 60/40 (S&P 500/US Treasuries*) portfolio would have seen drawdowns of -17% in 1987, -22% in 2002 and -31% in 2008.

A common approach to reducing this downside risk is to replace part of the stock and bond exposure with an uncorrelated, or negatively correlated, alternative asset, resulting in something like a 50-30-20 or 40-40-20 portfolio.  The issue here is the opportunity cost of replacing a familiar asset class like stocks and bonds with a non-traditional asset class – especially when it underperforms stocks and/or bonds.

As Corey Hoffstein at Newfound Research points out, Modern Portfolio Theory (MPT) quantified the benefits of diversification and that has led to investors looking to expand their investment options beyond traditional stocks and bonds.  Yet MPT actually says that in an efficient market, all investors should hold the optimal portfolio, say 60/40 for argument’s sake. Beyond that, investors should simply leverage down if they want less risk (ex. 45/30 plus 25% in cash) or leverage up if they are comfortable with more.

This is why WisdomTree’s innovative new ETF (ticker: NTSX) is interesting. They apply 1.5x accounting leverage to a traditional 60/40 portfolio to create exposure equivalent to 90% equities (S&P 500) and 60% bonds (laddered US Treasuries via futures). The idea is similar to that explained by Cliff Asness, co-founder of AQR Capital Management, in 1996. He argued that an “investor willing to bear the risk of 100% equities can do even better with a diversified portfolio”.

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